If there’s one message Jerome Powell has tried to drive home over the last two policy meetings, it’s that inflation would have to rise sharply in order to put rate hikes back on the table.
The Fed’s favorite catchphrases since October are “good place” and “remain appropriate”, each meant to convey a predisposition to hold rates steady, barring developments that would force a “material reassessment” of the outlook.
But the underlying message is that the reaction function is asymmetric. The bar for more cuts is infinitely lower than the bar for hikes.
At the December meeting, the committee indicated that policy will remain on hold in 2020, an election year, but it’s pretty easy to make a list of developments that could compel more easing. Making a list of things that would definitively force the Fed to hike, on the other hand, is difficult, at least if you’re confined to including only plausible scenarios.
Of course, things can change quickly, as we’ve seen over the course of the Fed’s epochal dovish pivot, but as it stands now, the read-through is that the market should be more sensitive to growth outcomes than minor gyrations in realized inflation. That goes double when you consider the Fed’s ongoing rethink of the policy framework, which could ultimately lead officials to tolerate persistent overshoots if it means “making up” for long periods where inflation fails to rise to target.
Meanwhile, investors are laser-focused on growth. The idea that some 70 global rate cuts and an abatement of trade tensions are set to usher in a pro-cyclical rotation is part and parcel of many year-ahead market outlooks. Rising inflation expectations are part of that story, but what the market really wants to see to vindicate the good vibes that have driven stocks to records and pushed yields up markedly from the August lows, is a combination of better growth outcomes and inflation that’s subdued enough to keep policymakers committed to accommodation.
Goldman underscores all of this in a new note.
“Sensitivity to inflation surprises picked up sharply in late 2017 and 2018 as the Fed hiked, as realized inflation moved towards the target, and as the risk of overheating entered the mainstream policy debate”, the bank writes.
That ended badly. In short, the Fed hiked and tightened and waxed hawkish (with the usual pushback from the perennial doves) until something snapped in October of 2018 (i.e., until Powell’s “long way from neutral” misstep). Over that period, the sensitivity of the short-rate to inflation surprises surged. As you can see from the chart, it’s since plunged.
“Following the sharp tightening in financial conditions at the turn of the year, the combination of renewed growth fears, declining core inflation, and the dovish Fed pivot resulted in a roughly 50% decline in inflation sensitivity”, Goldman goes on to say.
At the same time (and this is the mirror image), growth sensitivity rose markedly.
“In contrast, sensitivity to growth data picked up sharply in 2019, reflecting slowing growth and the return of recession fears”, the bank goes on to say, adding that “in fact, growth sensitivity in the bond market is already back to its level during the shale bust and capex-driven growth scare of 2016-17”.
So, what does this mean for 2020? Well, it means that assuming the economic outlook stabilizes, there’s scope for the bond market’s sensitivity to the incoming growth data to abate.
With Powell having made it clear that absent an almost unthinkable spike in inflation (made even more far-fetched by the almost total breakdown of the price Phillips curve, even as the wage curve has shown signs of life), a return to hikes isn’t in the cards, it’s possible that the market’s sensitivity to all incoming data will wane in the new year.
If you’re wondering how the election will play into things, Goldman added an election dummy variable to their model to find out. Ultimately, the bank discovered a “negative and significant ‘election effect’ on growth sensitivity, with reactions to growth surprises attenuating in the quarter of presidential elections”, but no significant change in inflation sensitivity.
Of course, it always comes back to the same old thing in the Trump-era – namely that history may not be the best guide.
If ever there were a good argument for why a given market dynamic might be “different this time” (for better or worse), Trump embodies that argument. And, indeed, when you look back at the interplay between the Fed’s reaction function and economic outcomes over the past two years, the dynamic has everywhere and always been shaped by the president, whether indirectly (e.g., through the threat of an economic overheat from the tax cuts) or directly, via his exhortations for lower rates on the excuse that inflation is non-existent and that he might ratchet up trade tensions without warning.